Market timing versus asset allocation

Last week, we discussed how diversified and concentrated portfolio structures are both capable of generating alpha. We also explained why market timing is risky because such strategies make large bets on fewer stocks. Several readers responded, stating that market timing was a rewarding asset allocation strategy to generate alpha. This argument raises two questions. One, is market timing same as asset allocation? And two, is it worthwhile pursuing such strategies?

This article explains how market timing is different from asset allocation. It then shows why market timing, though attractive, is risky. It reiterates last week's discussion — market timing should be pursued by those confident about their strategies and disciplined enough to use risk management to control losses.

Market timing vs asset allocation

Market timing and tactical asset allocation involve moving in and out of an asset class. There is, however, a difference.

Market timing refers to the process wherein the investor shifts between a risky asset such as equity and cash equivalents such as money market funds.

Consider an active trader or a professional money manager who engages in trend-following strategies using technical analysis or quantitative modelling. This trader or money manager would obviously move into equity when she expects the market to do well and move out of equity when she expects prices to decline. Importantly, when this trader is underweight on equity, she is overweight on cash equivalents, otherwise called tactical cash.

Tactical asset allocation, in contrast, refers to the process of shifting between risky assets — equity and bonds. An investor would overweight equity when she believes it would perform well and overweight bonds otherwise. An investor or a professional money manager will engage in tactical asset allocation within the broad framework of strategic asset allocation.

Suppose an investor decides to have a 60-40 equity-bond allocation with a tactical range of 10 per cent for her retirement portfolio. The investor then has a leeway to carry equity exposure between 50 and 70 per cent.

Why is this distinction between market timing and tactical asset allocation important?

Asymmetric returns

Bonds provide higher returns than money market instruments. This means that market timing carries higher levels of underperformance risk compared with tactical asset allocation.

The flip side is that market timing also carries potential for higher reward because of its larger exposure to equity. The question is: Should investors engage in market timing?

Empirical study conducted in this area argues that market timing is risky. There are two reasons to support this argument. One, if the investor or the professional money manager misses the days when the market finishes markedly higher, which happens for about 20 per cent of the total trading days in a year, the portfolio is likely to underperform its benchmark. And two, if the investor or the money manager is invested on the worst days, the chances of the portfolio recovering losses becomes difficult. This is because of the problem of negative returns-compounding.

Suppose a portfolio is currently worth Rs 15,000, gaining 50 per cent in one year on an initial investment of Rs 10,000.

This portfolio has to give up only a third (33 per cent) of its value to end-up with the initial investment of Rs 10,000.

If the portfolio instead declines 50 per cent in one year to Rs 5,000, it would then require 100 per cent gain to end-up with the initial investment of Rs 10,000! The loss-recovery process is, thus, steeper. And this makes market timing risky.

Conclusion

Market timing is nevertheless rewarding, which drives investors to engage in such strategies. It is, however, important to consider associated risks.

No amount of technical analysis or quantitative modelling is likely to help investors avoid losses due to noise trading. Strict risk management rules are necessary to control losses; for it is the management of losses that differentiates a successful market timer from the rest.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)

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